Hitting The Investment Strategy Sweet Spot
By: Sophie Mayrand
Rising pension fund liabilities and declining return on assets has put many pension funds into an underfunded position, prompting them to seek other ways to increase their return. Sophie Mayrand, of State Street Global Advisors, examines one approach – enhanced index management.
The funding structure of the Canadian pension industry has been shaken in recent years. The equitymarket downturn between 2000 and 2002 and the decline in interest rates that followed have left a number of corporate funds in the unenviable position of having to play catch-up with growing liability obligations. A three-year study of 68 large Canadian Defined Benefit pension plans found the country’s workplace pension plan assets declined $180 billion during the 2000 to 2002 period, a drop of almost 30 per cent. The factors behind the declines are the median net return of one per cent per annum on assets and an almost 10 per cent annual increase on pension liabilities.
Though only one of the challenges facing Canada’s pension industry – illdefined pension arrangements and ineffective governance are among the others – inadequate funding is forcing plan sponsors to rethink traditional styles of money management. Whether overseeing a pension plan, endowment, foundation, or personal account, money managers share a common goal: to generate as much return as possible while keeping risk levels tolerable. Though not a panacea, enhanced equity management is an investment strategy gaining awareness among financial professionals. It is designed to provide a modest amount of ‘excess return’ – any performance amount that exceeds its index – while closely tracking the risk characteristics of a benchmark such as the S&P/TSX Composite Index.
Enhanced equity management, often perceived as a hybrid of the more prominent passive and active equity styles, has been rapidly gaining acceptance in the United States, Europe, and Asia over the last few years, coinciding with the global stock market downturn. A lot has been written over the years on the efficiency of the U.S. equity market and the competitive advantage of lowcost, low risk passive, and enhanced strategies against struggling active managers.
On the other hand, Canadian equity investors are embracing the concept with a little more skepticism. The comment most often heard is why would anyone want a low risk strategy in an inefficient market like Canada? There are two possible answers to this question. It can be a highly efficient strategy (smart use of risk budget) and it can provide consistent value added over passive strategies in core-satellite approaches.
Enhanced Index Management
An enhanced strategy seeks a middle ground between the value-added potential of active management and the risk aversion of its passive counterpart. In essence, an enhanced style attempts to hit the ‘sweet spot’ of risk-return by means of skillful stock selection methodologies and the thorough understanding of the underlying risks when one is deviating from the strategic benchmark.
To categorize the management differences, an active manager may be looking for substantial investment returns, while the passive manager seeks the elimination of risk against its chosen benchmark (and, therefore, gives up any potential excess returns). The enhanced manager, on the other hand, strives for consistent, albeit somewhat modest, gains that fall somewhere in between. The actual stock selection process and underlying philosophy of enhanced managers will likely vary from one investment firm to the other (derivatives versus physical, quantitative versus fundamental, broad stock picking skills versus one-off arbitrage opportunities such as M&A announcements, index changes, or stub miss-valuations). Though there is no industry- wide performance consensus, an enhanced approach generally tries to exceed its benchmark by 50 to 250 basis points.
The Appeal Of Enhanced Investing
Enhanced Index Strategies are advantageously situated in an ‘ideal’ zone on the efficient frontier of investment opportunities (see Chart 1).
This ‘ideal’ zone is located on a portion of the efficient frontier (between the two vertical lines) where the ratio of excess return unit to risk unit (also known as the ‘information ratio’ or ‘IR’) is at its highest level. Successful enhanced management is not just about inching out returns that slightly surpass an index. It is also about using investment assets more efficiently; akin to the way a smart shopper looks for superior value for each limited dollar available to them. Think in terms of a ‘risk budget.’ Every investor has a certain amount of risk he or she can afford to spend without going over budget. As risk increases, incremental return slows (the law of decreasing incremental returns) because more aggressive active managers are often constrained by long-only strategies – and that is far from optimal portfolio construction. By taking smaller, but more efficient bets, respectively underweighting unattractive and overweighting appealing stocks in the universe, the use of the risk budget is maximized as is the information ratio of the investor.
The Core-Satellite Approach Revisited
In recent years, a lot has been said about the core-satellite approach, whereby Canadian pension fund managers separate their beta (passive) from their alpha (active). Generally speaking, the core portion is passive for stability while the satellite portion features a few ‘fueled’ investments to accelerate returns.
However, most core-satellite managers fail to consider the efficient use of their portfolio’s risk budget. Any linear combination of active and passive management (line Ain Chart 1) will be dominated by the efficient frontier since the passive strategy’s information ratio is equal to zero (the active manager’s return is diluted). And if the investor with a large pool of assets wants to diversify his manager risk, an enhanced/active index combination (50/50) will be more efficient than a passive/active combination (50/50). Let us take a closer look at the concept using simulated numbers for a Canadian enhanced and a more active strategy (see Table 1).
The advantages of enhanced index management are clear. Not only can it be more efficient than traditional active strategies (information ratio of 1.06 versus 0.71) or combinations of passive and active (same efficiency ratio as the active), they can also represent an excellent substitute to passive investments within a core-satellite approach through the use of an enhanced beta (IR of 0.8 versus 0.71).
Consistency Of Returns
The consistency of excess returns shown by U.S. and EAFE enhanced managers over the last few years is based on talent, but also on the benefits of diversification and the neutralization of unwanted risk (size, style, and market risk) for those managers focusing on stock selection strategies.
A typical enhanced index portfolio may be comprised of roughly 60 per cent of the stocks of the underlying index (about 125 stocks in the Canadian market). Diversification implies a reduction in specific risk. Each active position will contribute marginally to excess return. The natural result of these modest incremental contributions is that the pension plan investor will rarely ruin the fund’s performance because of a bad position. If we were to use a baseball analogy, we would be looking to hit singles regularly and not home runs followed by strike-outs.
By concentrating risks on proven abilities (such as stock picking) rather than on trends in style, capitalization, or markets, an enhanced strategy should perform well in diverse market environments. With competitive information ratios and constant excess returns, enhanced index strategies are very appropriate for the portfolio of investors looking for a controlled-risk alpha. They are also a good substitute for passive strategies given that they offer an exposure to an enhanced beta.
Explore The Enhanced
Advantage Though every financial situation is different, enhanced management is universally designed to help all pension funds pursue the best return for their investment dollar. While sticking to a traditional coresatellite management approach may be the easiest path for the uninitiated, it may not represent the most efficient trade-off between risk and return.
An enhanced management approach may also be particularly attractive for passive investors seeking modest incremental returns with little added risk or active investors exploring ways to grow their portfolios more efficiently. Because enhanced management closely resembles passive in practice, the limited degree of stock turnover should neither significantly raise trading costs nor reflect the higher turnover rates and expenses associated with active management.
Sophie Mayrand is a portfolio manager for State Street Global Advisors in Montreal.
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